Fair Value Macro Hedging Implementing a Highly Efficient Hedge Accounting Methodology

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Fair Value Macro Hedging Implementing a Highly Efficient Hedge Accounting Methodology Powered By Docstoc
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                <p><strong>Introduction </strong></p>
<p>Financial institutions that advance fixed rate loans are exposed to
interest rate risk and credit risk. The economic impact of interest rate
risk is typically hedged through the use of interest rate derivative
instruments. However, with the advent of fair value accounting rules,
which require derivative instruments to be marked-to-market, the use of
such derivatives can generate volatility in the Profit &amp; Loss
statement as interest rates rise and fall. To reduce such volatility,
special accounting treatment, or hedge accounting, can be applied when
specified criteria and conditions are met.</p>
<p>When the volume of loans is relatively low, hedging and hedge
accounting can be applied at the individual loan level. For higher volume
portfolios - particularly mortgages and personal finance loans – the
costs and manual effort involved with documentation, monitoring and
measuring means that it is impractical to apply hedge accounting at the
individual loan level.</p>
<p>As the International Accounting Standard for the recognition and
measurement of financial instruments (IAS 39) evolved, changes were made
which enable a financial institution to group underlying exposures (for
example, mortgages and loans with similar characteristics) and apply a
more simplified and cost-effective hedge accounting process, macro hedge
accounting. This process is better aligned with the internal management
process whereby interest rate risk is managed at the aggregated
<p>This paper details the methodology and approach that can be
implemented under IAS 39 paragraph 81.A to achieve a highly efficient
fair value macro hedging process.</p>
<p>Once implemented, a financial institution will have a hedge accounting
methodology that is aligned with the way the underlying business is
managed from an economic and risk perspective. The process implemented
will be cost-effective, thus ensuring that the benefits of removing
P&amp;L volatility are fully realised.</p>
<p><strong>Hedging Interest Rate Risk </strong></p>
<p>When a financial institution grants a fixed rate loan, it will be
exposed to changes in market levels of interest rates and credit spreads.
First, earnings may vary as funding costs rise and fall. Second, the
economic value of the loan portfolio will rise when rates fall and vice
<p>Interest rates risk can also affect prepayment behaviour. With fixed
rate loans such as mortgages and personal lending, there is an implicit
call option written by the financial institution. That is, the customer
has the right to repay their loan before the contractual maturity date.
If interest rates fall, customers may re-finance their loans at a lower
rate (and potentially elsewhere) and the financial institution will have
to re-lend the funds at a lower rate thus reducing interest income.</p>
<p>Financial institutions typically seek to manage their interest rate
margin by converting fixed rate assets and fixed rate liabilities to
floating rates, respectively. Interest rate derivatives such as interest
rates swaps and swaptions are typically utilised for this purpose.</p>
<p>For larger volume portfolios, financial institutions will hedge at the
portfolio level, not at the level of an individual loan. For example, a
tranche of 500 million 3 year fixed rate mortgages may be offered to the
market at a rate of 3.45% for a period of time. Once drawn down, this
tranche will consist of many smaller individual loans. In this example,
the financial institution may transact a Pay Fixed Receive Libor interest
rate swap as a hedge.</p>
<p>From an economic perspective, this transforms the tranche to a
floating rate portfolio and locks in an interest rate margin (assuming
floating rates funding of the same basis/tenor and no prepayments).</p>
<p>Prepayment risk may also be hedged through the use of derivatives (for
example, amortising swaps representing the expected prepayment behavior
of the portfolio or through the use of swaptions). In some markets,
prepayment risk is mitigated by the inclusion of prepayment penalties in
the loan contract.</p>
<p><strong>Economic and Accounting Mismatch </strong></p>
<p>Under IAS 39 accounting principles, different accounting treatments
apply to loans and derivatives; consequently, there may be an accounting
gain or loss from a hedged portfolio in an accounting period, despite the
economic hedge.</p>

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<p>In simple terms, earnings are generated for the loans on the basis of
interest accrued in each period, while the derivative acting as a hedge
has to be marked-to-market. By way of the above example, if interest
rates rise the fixed rate mortgages will still accrue at 3.45%. However,
the Pay Fixed Receive Float swap will show a mark-to-market loss in the
<p><strong>Hedge Accounting Without Paragraph 81.A </strong></p>
<p><em>Handling Individual Loans</em></p>
<p>If Hedge Accounting treatment is applied and the stringent criteria of
IAS 39 are met, then the change in the value of the swaps in each period
can be offset against the change in the value of the mortgages due to
changes in the benchmark interest rate e.g Libor.</p>
<p>One of the core tenants of IAS 39 hedge accounting, however, is that
hedges need to be applied to a designated individual item. Consequently,
this would mean that details of every individual fixed rate loan would
have to be captured, documentation generated to link each individual loan
to a hedging instrument, and the effectiveness of the hedging
relationship tested for every individual loan at the point of loan
origination and in each subsequent accounting period.</p>
<p>The impact of the above is a process that becomes unworkable in
practice and where the costs outweigh the benefits of smoothing out
P&amp;L. The volume and granularity of data to be captured, the systems
required to link and track the hedge relationships, and the manual effort
within the accounting department to operate the process on an on-going
basis, are key considerations.</p>
<p>To qualify for hedge accounting treatment, hedges have to reflect the
contractual re-pricing of the underlying loans. On an economic basis,
however, a financial institution manages the portfolio and risks on the
basis of expected re-pricing, after applying prepayment models based on
historical experience, the age and seasonality of a portfolio tranche and
the interaction between the level and direction of interest rates and
customer behaviour.</p>
<p>In addition, as individual loans prepay, the hedge relationships have
to be re-adjusted and other individual loans substituted into the hedged
portfolio. The hedge should be de- and re-designated each time to reflect
the changes to the underlying hedged items.</p>
<p><strong>Hedge Accounting With Paragraph 81.A </strong></p>
<p><em>How Does Paragraph 81.A Address Hedging Individual Loans?</em></p>
<p>IAS 39 81.A addresses this issue in a fair value macro hedge of the
interest rate exposure by allowing you to designate an <em>amount of a
currency </em>rather than individual assets as the exposure. This better
aligns with the internal risk management process whereby portfolio
exposures are aggregated into tranches and time buckets representing the
re-pricing period. The gain or loss related to the hedged items are
reported as one of two separate line items, rather than allocated across
many hedged items.</p>
<p>(Note that while a financial institution will often hedge economically
on a net basis after aggregating assets and liabilities, this is not
allowable under IAS 39 paragraph 81.A – the amount designated will
therefore represent the gross amount of loans re-pricing in a
<p><em>How Does Paragraph 81.A Address The Issue Of Pre-
<p>When aggregating individual loans into re-pricing time buckets, IAS 39
paragraph 81.A supports aggregation based on the expected, rather than
contractual, re-pricing dates.</p>
<p>The re-pricing date is the earlier of the dates when the item is
expected to mature, or the date when the interest rate resets to a market
rate. In many cases, it will be possible for an item to be prepaid - for
example, a borrower might repay a bank loan early. In such cases, the
entity must use the expected re-pricing date (based on its own or
industry experience), rather than the contractual date. The time
‘buckets' that the company identifies must be sufficiently narrow so
that all the items within a ‘bucket' are homogeneous with respect to
the interest rate risk being hedge.</p>
<p>The expected re-pricing dates can be estimated at the inception of the
hedge and throughout the term of the hedge, based on historical
experience and other available information, including information and
expectations regarding prepayment rates, interest rates and the
interaction between them.</p>
<p><em>How Does Paragraph 81.A Address the Issue of Over-
<p>There is a risk that expectation does not match reality with regard to
the actual level of prepayments and that those prepayments are higher
than anticipated, resulting in an over-hedged portfolio.</p>
<p>When designating the <em>amount of a currency </em>as the exposure, it
is recommended that some headroom is built in. That is, an amount
reflecting 80-90% of the expected exposure is designated as the hedged
exposure, thereby allowing similar loans to drop into the exposure in the
event of a higher degree of prepayments occurring.</p>
<p><strong>Conclusion and Benefits </strong></p>
<p>Implementing this methodology and approach to fair value hedging of
interest rate risk in a fixed rate loan portfolio will mitigate profit
and loss volatility very efficiently when done through an automated
process. Removing the requirement to track and adjust the individual
items making up the portfolio ensures that it is practical in operational
terms to handle large volumes of small value items. The costs associated
with complying with the onerous requirements of hedge accounting will be
significantly reduced.</p>
<p>Once implemented, a financial institution will have a hedge accounting
methodology that is aligned with the way the underlying business is
actually managed from an economic and risk perspective.</p>
<p><em>Applying the IAS 39 Paragraph 81.A Methodology</em></p>
<p>To correctly apply this hedge accounting methodology a financial
institution must comply with the procedures set out in (a)–(i) below
and paragraphs AG115–AG132 of IAS 39.</p>
<p>(a) As part of its risk management process, the entity identifies a
portfolio of items whose interest rate risk it wishes to hedge.</p>
<p>(b) The entity analyses the portfolio into re-pricing time periods
based on expected, rather than contractual, re-pricing dates.</p>
<p>(c) On the basis of this analysis, the entity decides the amount it
wishes to hedge.</p>
<p>(d) The entity designates the interest rate risk it is hedging. This
risk could be a portion of the interest rate risk in each of the items in
the hedged position, such as a benchmark interest rate e.g. Libor.</p>
<p>(e) The entity designates one or more hedging instruments for each re-
pricing time period.</p>
<p>(f) The entity assesses at inception and in subsequent periods,
whether the hedge is expected to be highly effective during the period
for which the hedge is designated.</p>
<p>(g) Periodically, the entity measures the change in the fair value of
the hedged item</p>
<p>1. If the hedge is highly effective the entity recognises the change
in fair value of the hedged item as a gain or loss in profit or loss and
in one of two line items in the balance sheet without having to change
the fair value need of the individual assets or liabilities.</p>
<p>(h) The entity measures the change in fair value of the hedging
instrument(s) (as designated in (e)) and recognises it as a gain or loss
in profit or loss.</p>
<p>(i) Any ineffectiveness will be recognized in profit or loss as the
difference between the change in fair value referred to in (g) and
<p><em>Hedge Documentation Content:</em></p>
<p>(a) Which assets and liabilities are to be included in the portfolio
hedge and the basis to be used for removing them from the portfolio.</p>
<p>(b) How the entity estimates re-pricing dates.</p>
<p>(c) The number and duration of re-pricing time periods.</p>
<p>(d) how often the entity will test effectiveness</p>
<p>(e) the methodology used by the entity to determine the amount of
assets or liabilities that are designated as the hedged item</p>
<p>(f) Whether the entity will test effectiveness for each re-pricing
time period individually, for all time periods in aggregate, or by using
some combination of the two.</p>                <!--INFOLINKS_OFF-->

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